We believe we have turned the page on the 2011-2015 period in which financial markets behaved in such odd ways, and expect a strong multi-year period for thoughtful and disciplined small-cap active management.

Small-Caps
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Small-Caps

By any measure, 2016 was a terrific year for small-cap stocks, one that featured a double-digit positive return for the Russell 2000 Index, which advanced 21.3%, and a solid advantage over their large-cap counterparts.

It was an even better year for small-cap value stocks and a highly rewarding one for cyclical sectors. These last two factors were critical in boosting results for certain active management approaches within the asset class, including a number of our own.

Arguably even more important was what these developments may be telling us about the subsequent direction of small-cap equity returns. We flesh out the details later in this letter, but these three reversals—positive results for small-caps, leadership for value over growth, and outperformance for cyclicals—should be key in setting the tone for the direction of small-caps going forward. They coalesced around the central, normalizing force of rising interest rates.

The major impact of these reversals was both highly welcome and long overdue.

We saw 2015—a year in which large-cap beat small-cap, the Russell 2000 had a negative return, and market leadership was extremely narrow—as a hinge year. It marked the transition out of the period that began in 2011, when an unprecedented amount of monetary intervention into the global economy had the unintended effect of stoking an intense appetite for yield and safety at one extreme of the U.S. equity markets and a hunger for high risk at the other.

The bottom of a commodity super cycle, with the attendant slowdowns in the world’s largest developing markets, only exacerbated the challenges then faced by value stocks and active management approaches.

As has usually been the case historically, the longer market trends last, the more regularly they are mistaken for permanent realignments. In this most recent instance, the consensus lined up around the perpetuation of near-zero rates, growth stock dominance, and the futility of active management.

Article by Royce Funds